1. Financial Market Theory
Thursday, October 4, 2018
Professor Edwin T Burton

2. The Capital Asset Pricing Model
Markowitz – mean, variance analysis
Tobin – the role of the risk free rate
Sharpe (and others) – beta and the market basket
October 4, 2018

3. Main Conclusion of Markowitz Theory
Mean
Boundary of “feasible” portfolios
“Efficient” Portfolios σ σ
October 4, 2018

4. Tobin’s Result Mean Use of Leverage E Risk Free Asset
Standard Deviation
October 4, 2018

5. The Capital Asset Pricing Model
Markowitz – mean, variance analysis
Tobin – the role of the risk free rate
Sharpe (and others) – beta and the market basket
October 4, 2018

6. Capital Asset Pricing Model
Makes all the same assumptions as Tobin model
But Tobin’s model is about “one person”
CAPM puts Tobin’s model in equilibrium, by assuming that everyone faces the same portfolio choice problem as in Tobin’s problem
Only difference between people in CAPM is that each has their own preferences (utility function)
October 4, 2018

7. CAPM – two conclusions M – the “efficient” basket
Bill Sharpe
M – the “efficient” basket
The pricing rule based upon “beta”
October 4, 2018

8. Capital Market Line M Rf Mean What is M ?
Answer: contains all “positively”
priced assets, weighted by their
“market” values. Rf
STDD
October 4, 2018

9. i = Rf + i [M – Rf] i M Security Market Line Mean Rf
Beta 1
October 4, 2018

10. Things to think about Beta is not volatility Beta can be negative
M contains everything of value, weighted by market value
Excess return ≡ E[R] – Rf
“Beta equation” relates excess returns
October 4, 2018

11. How do you test this theory
You need M
Or some proxy for M
Usually S&P500 or Russell 3000 used as a proxy for M in beta calculations
October 4, 2018

12. Richard Roll’s Critique (1977)
Using a proxy for M won’t work
CAPM could be false
But the proxy might make it look true
CAPM might be true
But tests using the proxy might make it look false
Conclusion: theory is not testable unless you have the true M
October 4, 2018